You’ve tried it all – eating Raman noodles twice a day, creating a budget, cutting your cable TV – but despite those efforts, your credit card debt kept growing and now you’re struggling just to make the minimum monthly payments. It’s becoming clearer by the day you need help.
But what sort of help?
People in your situation usually narrow it down to two options: hope a debt settlement company can negotiate a way out, or find a nonprofit credit counseling agency that produces an affordable solution. However, before picking up the phone, you need to be familiar with how the two differ. Choosing poorly could hurt your credit rating, damage your finances and not resolve your indebtedness.
Debt settlement companies advertise their ability to lower your debts, but they often don’t add that they are for-profit businesses that charge steep fees for results that are seldom guaranteed. Credit counselors, by contrast, are usually nonprofit companies that charge low or no fees to guide you through a financial thicket and help you emerge with no debts and repaired credit rating.
Both approaches aim at lowering or clearing your debt in a 3-5 year span, but they use different tactics and the cost to you can be significant if you make the wrong choice. Before you decide which solution fits your objective, it pays to become explore:
- How each technique works
- How likely they are to resolve your financial problems
- Whether the outcome will include a plan for keeping you out of debt in the future
How Does Debt Settlement Work?
Debt settlement companies offer to play hardball with your creditors in hopes they can convince them to accept less than what you owe. The plan is simple: Instead of making monthly payments to your credit card issuers, you deposit funds in an escrow account that you control, but the debt settlor maintains. When the account grows to a certain size – usually 50% of what you owe – the debt settlor contacts your card companies and proposes a settlement.
If the card company agrees to the proposal, the debt settlement company receives a fee that can be a set amount or, more likely, a percentage of the original debt amount.
The strategy turns on the assumption that creditors or debt collectors are eager to recover at least something on unsecured debt and will accept a big reduction in what is owed in exchange for a payment. They don’t always do this, and some refuse to deal with debt settlors.
Debt settlement can be risky and costly. The costs come in two forms: fees the debt settlement company charges and penalties and interest the credit card issuer will add to your balance if you stop making monthly payments. Consumer watchdogs often advise against doing business with debt settlement companies, which are usually for-profit businesses that are mostly interested in making money from you.
Consider the advantages and disadvantages of debt settlement before deciding whether to contract with a company.
Pros of Debt Settlement
The main advantage, if the settlement company negotiates successfully, is you clear your debt for less than you owed, allowing you to become debt free more quickly than if you continued paying your debts without a settlement. Since a settlement company tries to get creditors to agree to accept about half of what you owed, the path out of debt can be faster. Once the debt is settled, creditors and debt collectors will stop calling you and the threat of a collection lawsuit disappears. Settlement companies can’t charge a fee until they have settled at least one of your credit card debts.
Cons of Debt Settlement
There are several. Debt settlement companies often charge high fees but can’t promise results. Even if they are successful in reducing debt, the fees and the unpaid interest and late payment charges on the debt can add to what you initially owed, reducing your actual savings.
Settlement will damage your credit rating, since credit card issuers or debt collectors are likely to report the amount they forgave to the nation’s three large consumer credit reporting agencies. Taxes are another problem: the IRS will treat the amount you didn’t pay creditors as income in the year the debt was settled, requiring that you pay taxes on it. Before entering a debt forgiveness settlement, talk to an accountant or tax lawyer to better understand the consequences.
Debt settlement scams are widespread, so watch out. If the settlor demands that you pay the full fee for its services upfront, look for another company. Also avoid companies that say they are using a “new government program” to eliminate credit card debt or those that tell you to stop communicating with your creditors.
Though the debt settlement industry says it has weeded out problem companies, recent evidence suggests otherwise. The Consumer Financial Protection Bureau reached a $25 million settlement with the nation’s biggest debt-settlement company in July 2019 over allegations that the company, Freedom Debt Relief, charged customers in advance for debt-relief services, which is illegal. The federal suit also alleged that Freedom Debt charged fees, often in the thousands of dollars, even before attempting to negotiate with its clients’ creditors.
Debt settlement as a strategy is high stakes poker. If the debt settlor can’t win over your creditors and eliminate all your debt, the holdout creditors who refused to settle could wipe out whatever savings your realized with fees and interest charges.
Given the negatives, you should be very leery about using a debt settlement company.
What Is Credit Counseling?
Credit counseling is a free service offered by nonprofit debt agencies to help people manage their money, work off a monthly budget and understand the different solutions available for dealing with credit card debt.
Certified credit counselors try to accomplish two things. First, they review your debt and try to help you understand how your finances became so imbalanced and how to avoid falling into unmanageable debt again. As they ask questions and review your accounts, they make suggestions about how you might better manage credit.
Second, they’ll try to create a repayment plan that lowers your monthly payment by reducing the amount of interest owed. Debts are usually paid off in three to five years. You’ll live a more austere life during the repayment period. The credit counselor will combine all your debts into a single monthly payment which the counselor will collect and distribute to your creditors.
Pros of Credit Counseling
Creating a manageable debt payment plan is the reason people seek out credit counseling. During your initial consultation, the counselor will review your debts and your income to determine whether a debt management plan actually will work. If you have enough money coming in to make a plan work, the counselor will offer to consolidate your debts into a single monthly payment. This involves contacting your creditors, who must agree to the plan. If you make minimum payments on time, your consumer credit rating won’t suffer demerits that may have resulted from missed or late payments.
Plans usually focus on unsecured credit card debt, but counselors might be able to include medical and department store debt in the mix. Since you repay what you owe at a lower interest rate or a lengthened repayment period, you won’t owe the additional taxes that typically accompany a debt settlement. Unlike debt settlors, most credit counselors are nonprofit companies and charge a monthly fee for their services. Always ask about fees before you meet with an agency.
Cons of Credit Counseling
Debt management plans take time. Your debts aren’t settled or discharged, so it might take 3-5 years to pay them off. If you miss a payment, the card companies can eliminate the concessions they offered to start the program. You are required to put away all but one of your credit cards and that one is only to be used in emergencies. During that time, you will probably need to forgo luxuries and direct a sizable part of your income to the debt payment plan.
Is Debt Settlement or Credit Counseling for You?
Credit counseling is usually the best alternative if you can afford the monthly payments and have the discipline to live on a tight budget for several years. The amount of time it will take depends on your income, your fixed expenses, the debt management plan your counselor devises with your creditors and your commitment to making every required payment on time.
Debt settlement can be expensive. Settlement company fees are often high and the damage to your credit score is considerable, restricting your ability to borrow in the future at market interest rates. But it can be faster than a debt management plan. Because the fees are high and debt settlement companies are sometimes revealed as scams, you might consider trying to negotiate a settlement directly with your creditors. Whether you use a settlement company or go it alone, you generally have to stop making payments before you can get a creditor to agree to a debt reduction. You also must have money in escrow or in an account available to pay your creditors if they agree to a reduction in debt.
Consider Morton, 40, a foundry worker who earns $45,000 a year and has $15,000 in credit card debt. He can only afford minimum monthly payments on his four credit cards and each month his debt increases as he struggles with an average 22% APR on his unpaid balances. He knows he needs a plan.
A credit counselor might be able to consolidate his debt, lowering his interest to an APR of 6% to 8% while requiring that he pay down principal every month. A debt settlement company would tell him to stop making any payments and instead contribute money to an escrow account that it will use to try to settle his debt. Morton feels that if he finds a second job, he should be able to work through a debt management plan. After reviewing the pros and cons, he opts to see a credit counselor.